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Day 11 Financial Options
Day 11 Financial Options
Financial Options
António Barbosa
(antonio.barbosa@iscte-iul.pt)
Outline
1 Example
2 Volatility
3 Discrete dividends
5 Summing up
Outline
1 Example
2 Volatility
3 Discrete dividends
5 Summing up
Example (1/7)
Let’s revisit Example 1 of Day 07
Example (2/7)
Example (3/7)
Next, we look on the tables for the values closest to N (−d1 ) and
N (−d2 ) and interpolate them
N (0.59) − N (0.58)
N (−d1 ) = N (0.5846) = N (0.58) + (0.5846 − 0.58)
0.59 − 0.58
0.7224 − 0.719
= 0.719 + (0.5846 − 0.58) = 0.7206
0.59 − 0.58
N (0.71) − N (0.7)
N (−d2 ) = N (0.7096) = N (0.7) + (0.7096 − 0.7)
0.71 − 0.7
0.7611 − 0.758
= 0.758 + (0.7096 − 0.7) = 0.7610
0.71 − 0.7
Example (4/7)
Example (5/7)
Finally, we plug everything into the Black-Scholes formula
p0 = −S0 N (−d1 ) + Ke−rT N (−d2 )
= −4.6 × 0.7206 + 5e−0.01×0.25 × 0.7610
= 0.4807
The price of the put is then
0.4807€ × 100 = 48.07€
The replicating portfolio is
∆ = −N (−d1 ) × 100 = −0.7206 × 100 = −72.06
B0 = Ke−rT N (−d2 ) × 100 = 5e−0.01×0.25 × 0.7610 × 100 = 379.55€
By the way, the risk-neutral probability of exercising this option at
expiration is
N (−d2 ) = 0.7610 = 76.1%
António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 8 / 35
Example Volatility Discrete dividends Continuous dividend yield Summing up
Example (6/7)
Now, suppose the stock price 0.125 years from today is 5.025€
this corresponds to the price after one up move when we used the
binomial model on Day 07
If you compute the price of the put in this scenario using the
Black-Scholes formula using these parameters
you obtain
p0.125 = 0.1614€ × 100 = 16.14€
But the value of the replicating portfolio is
∆ × 5.025€ + B0 e0.01×0.125
= −72.06 × 5.025€ + 379.55€ × e0.01×0.125
= 17.92€
Example (7/7)
Outline
1 Example
2 Volatility
3 Discrete dividends
5 Summing up
In the case of a (near) ATM call option, the value of the option
no longer depends exclusively on the occurrence of an extreme
positive return and so the implied volatility is less overestimated
or even underestimated
The implied volatility from calls and puts is the same:
therefore the implied volatility of a deep ITM put (which
corresponds to the implied volatility of a deep OTM call) is
overestimated
similarly, the implied volatility of a deep ITM call (which
corresponds to the implied volatility of a deep OTM put) is also
overestimated
And this is how we end up with a volatility smile
Volatility smile
Volatility skew
You’ll get a volatility skew if on top of fat tails, the real distribution is
not symmetric as assumed in the Black-Scholes model
António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 22 / 35
Example Volatility Discrete dividends Continuous dividend yield Summing up
Outline
1 Example
2 Volatility
3 Discrete dividends
5 Summing up
Example (1/3)
Example (2/3)
The present value of all dividends to be paid during the life of the
option is
2
P V (D) = 0.2e−0.01× 12 = 0.1997
and so
S0∗ = S0 − P V (D) = 4.6 − 0.1997 = 4.4003
The model parameters are
Example (3/3)
Next, we look up on the tables the values closest to N (−d1 ) and
N (−d2 ) and interpolate them
The end result is
N (−d1 ) = N (0.9396) = 0.8263
N (−d2 ) = N (1.0646) = 0.8565
Plugging everything into the Black-Scholes formula,
p0 = −S0∗ N (−d1 ) + Ke−rT N (−d2 )
= −4.4003 × 0.8263 + 5e−0.01×0.25 × 0.8565
= 0.6358
The price of the put is then
0.6358€ × 100 = 63.58€
Without dividends it was 48.07€ (dividends increase the value of a put
option)
António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 27 / 35
Example Volatility Discrete dividends Continuous dividend yield Summing up
Outline
1 Example
2 Volatility
3 Discrete dividends
5 Summing up
c0 + Ke−rT = p0 + S0 e−qT
Outline
1 Example
2 Volatility
3 Discrete dividends
5 Summing up
Summing up